Monetary Policy Seems to Have Hit Its Limits
The weak economic response is partly due to factors beyond the ability of central banks (and governments) to change and partly due the failure of governments to help, which has unfairly placed the entire policy burden on central banks. The central banks are not at fault. In every case, they’re doing all they can, even if it is now ineffectual.
Japan is an excellent example of a central bank now doing whatever it can to promote growth and higher inflation, but with very little success. So they keep trying, but the latest policy change is highly likely to do very little. They have already depressed market interest rates into negative territory without much economic response. Steepening the yield curve by pushing up long-term interest rates while keeping short rates at zero or below will achieve little, nor will it improve bank profitability, since Japanese banks don’t hold enough investments in long-term securities to matter. The Abe Government was elected on a campaign of three arrows to promote growth: expansionary monetary policy, fiscal stimulus, and economic reform. Fiscal stimulus is limited by the country’s massive budget deficit, while economic reform comes mostly as hot air spoken by politicians. It is the central bank that has done all the work. The government needs to implement regulatory reform, but despite its promises, that has proven impossible politically.
Europe also suffers from ineffectual government leadership, so much of the burden to counter economic weakness has fallen on the ECB. Under Draghi, the ECB has been very aggressive in injecting liquidity into the financial system to promote stronger growth, but the central bank has received very little help from government. Counterproductively, many national governments have objected to or discouraged fiscal stimulus, especially in those countries that historically ran large budget deficits, so those nations have been consigned to very weak growth. And they have coddled their banks, hiding loan problems instead of forcing them to write off bad debts and to raise capital, precisely the opposite of the response of our government. So the banks haven’t been able to help. As for reform, a few nations have implemented meaningful structural reforms, including Ireland and Spain, so those countries enjoy solid recoveries, while others, notably France and Italy, continue to struggle. Again, the central bank has done all it can, while the central governments have been unable to implement the regulatory or structural reforms that are needed.
Domestically, the federal government provided fiscal stimulus during the deep recession in 2008, which was very helpful in getting the recovery started, but its restrictive stance since then has been holding growth back. Regulators have been so focused on safeguarding banks against losses that they have created severe hurdles against bank lending activity. Moreover, every bank mistake becomes quick justification for more “reforms” that are designed to punish banks, which renders them less effective as lenders. Politicians would apparently prefer grandstanding before the voters,
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even if it damages the economy. Non-bank financial companies are stepping into
this breach, but it will take them years to fully replace banks and they also happen to be far less governed by regulators or policymakers. The government’s freezing of the Dakota Access pipeline is another example of a last minute, after-the-fact regulatory hurdle that inhibits capital investment. Here, too, our dysfunctional government has been too busy playing politics to act responsively on policy. Demographics and slower gains in productivity have moderated the pace of recovery. The Fed has been the only fully functional macro policy player and it has been effective in promoting expansion, albeit a weaker one than normal. It is highly disappointing that it has received so little support from the rest of the Washington establishment.
Nonetheless, the Fed is capable of making mistakes and may be close to a serious one. Economic growth has been vigorous enough to tighten the labor market to the point that shortages are now common, especially in many more specialized occupations. Wage rates are beginning to accelerate, as are prices. While we hope these accelerations remain gradual, it is no longer appropriate for interest rates to remain at emergency low levels. Within the Fed, voices are being heard advocating for a policy change to begin a slow process of normalizing interest rates. While Janet Yellen and a number of colleagues would prefer to keep rates low for longer to promote even further declines in the unemployment rate, this will come at the price of higher inflation and risk a surge in interest rates later that could set the stage for the next recession. It would be better to start raising rates now to prolong the expansion. We will see if the Fed remains the most effective policymaker in Washington.
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